On January 22, 2014, a Securities and Exchange Commission (SEC) administrative-law judge issued a decision banning the Chinese units of Ernst & Young, KPMG, Deloitte Touche Tohmatsu, and PricewaterhouseCoopers from auditing United States-listed companies for a period of six months because the Chinese firms refused to produce their work papers to SEC investigators. Those firms and a fifth defendant firm—BDO China Dahua CPA Co., Ltd.—also received the sanction of censure. BDO China Dahua CPA Co., Initial Decision Release No. 553, 2014 SEC LEXIS 234 (A.L.J. Jan. 22, 2014). The firms filed an appeal with the SEC on February 12. The appeals process will delay the effective date of the suspension, and the ruling is not expected to affect the firms’ 2013 audits. However, in addition to making it more difficult for Chinese firms doing business in the United States to obtain audits, the ruling is likely to affect ongoing and future cooperation efforts between U.S. and Chinese securities regulators.
The ruling by Administrative Law Judge Cameron Elliot came in two consolidated administrative actions brought by the SEC against the Chinese units of the accounting firms for refusing to release audit work papers and other documents related to clients of the accounting firms that were under investigation by the SEC. Because both sides’ arguments as well as Judge Elliot’s analysis touched on United States-China regulatory relations, including ongoing cooperation discussions, large portions of Judge Elliot’s 112-page decision were sealed.
The clients at issue were 10 China-based companies listed on U.S. exchanges. The SEC requested the accounting firms’ audit work papers in the course of its investigations of the Chinese clients and, after the firms refused to release the work papers, brought administrative actions against the accounting firms. The firms stated that although they were willing to release the work papers, Chinese secrecy laws prohibited them from doing so. The firms had consulted with the China Securities Regulatory Commission (CSRC) about the SEC requests and were told that they could not release the work papers, and that the SEC would have to request them directly from the CSRC. The firms provided their work papers to the CSRC and contended that this was an issue to be decided by the U.S. and Chinese governments and regulators, not by the firms. Between the closing of the record of the action and the release of the decision, the CSRC had produced to the SEC some, but not all, of the work papers originally sought.
The firms were charged with violation of Sarbanes-Oxley section 106(e), which provides that “willful refusal to comply . . . with any request by the Commission . . . under this section, shall be deemed a violation of this Act.” The firms argued that “willful refusal” required proof of bad faith or bad intent and that the firms did not refuse to produce the documents in bad faith but to comply with Chinese law. Noting that “willful” was not defined in Sarbanes-Oxley, Judge Elliot looked to the Exchange Act and found that “willful refusal to comply” in section 106(e) means “choosing not to act after receiving notice that action was requested,” without regard to good faith. The firms had each received notice of and chose not to comply with at least one request from the SEC and therefore willfully violated a provision of the federal securities laws, making sanctions appropriate.
Although the firms’ good faith or lack thereof was irrelevant to liability, the firms’ arguments that they acted in good faith out of fear of violation of Chinese law were considered in the assessment of sanctions to be imposed. While noting that he may lack authority to interpret Chinese law, Judge Elliot also found that “a good faith effort to obey the law means a good faith effort to obey all law, not just the law one wishes to follow.” Even if the firms’ noncooperation was based on fear of violating Chinese law, the firms knew when they registered with the Public Company Accounting Oversight Board (PCAOB) that they were subject to applicable U.S. laws and that they might be required to provide audit work papers.
Judge Elliot found that the firms operated accounting businesses and performed audit work for U.S. issuers knowing that audit work papers could be requested and knowing that a failure to produce accounting work papers to regulators could be a violation of Sarbanes-Oxley section 106. The firms continued to audit U.S. issuers knowing that if they were asked to cooperate in SEC investigations by producing work papers, they would fail to do so and risk violating Sarbanes-Oxley. Thus, Judge Elliot found that the firms did not act in good faith. However, he also found that the firms did not act with scienter. The firms had no intent to defraud, nor were they reckless in that their conduct constituted an “extreme departure” from the standard of care.
Judge Elliot also rejected the firms’ contention that the effects of a bar would have “substantial negative collateral consequences” for Chinese-based issuers. The firms argued that if they were barred from practice, smaller auditing firms could not adequately replace them. Chinese firms would be unable to receive audits and therefore be unable to trade on U.S. exchanges, causing a decline in capitalization and harm to investors. However, Judge Elliot noted that other accounting firms had performed audits on China-based U.S. issuers and that the large firms’ superior reputations did not mean that smaller firms would be inadequate auditors. Judge Elliot found that the firms’ “dire predictions of investor losses, delisting, and loss of market capitalization, which are generally predicated on a lack of adequate substitute auditors, are unrealistic and unpersuasive.”
Judge Elliot declined to impose the sanction requested by the SEC—permanently barring the firms from issuing audit reports filed with the commission or from playing a 50 percent role or greater in preparing such audit reports—finding a permanent practice bar unwarranted particularly due to the lack of scienter on the part of the firms. He found that censure alone would be an insufficient remedy and deterrent. Therefore, each of the Chinese units of the Big Four received the sanction of censure and was denied the privilege of appearing or practicing before the SEC for a period of six months. BDO China Dahua CPA Co. received the penalty of censure only, as it had previously ceased doing audits of China-based U.S. issuers, and Dahua is no longer a part of BDO.
The firms appealed the decision on February 12. The appeal will be heard by the five members of the SEC. If the decision is upheld after the SEC review process, the firms can seek judicial review through a further appeal to a U.S. court of appeals. This appeals process could ultimately delay the effect of the ruling and imposition of sanctions for several years.
Effects of the Decision
The ruling represents a potential setback in ongoing cooperation efforts between U.S. and Chinese regulators. U.S. regulators have been attempting to receive greater access to audit documents for Chinese firms that issue securities in the United States for several years. Chinese regulators have generally taken the position that U.S. regulators do not have oversight authority over China-based audit firms. Accounting firms that audit companies listed on U.S. exchanges, however, subject themselves to applicable U.S. laws and regulations.
In May 2013, the PCAOB entered a memorandum of understanding on enforcement cooperation (MOUEC) with the CSRC and China’s Ministry of Finance that was intended to make it easier for regulators from both countries to access audit information when investigating fraud. The MOUEC authorizes production of audit work papers to the PCAOB and the forwarding of these work papers to the SEC. The MOUEC only clearly permits the PCAOB to seek documents from a Chinese audit firm if it has evidence of accounting fraud at a Chinese company. It does not provide U.S. regulators with the authority to regularly review audits by Chinese firms. Nor does the MOUEC allow the SEC to request work papers directly from the CSRC.
The SEC has brought multiple accounting-fraud actions in the past few years against Chinese firms entering the U.S. market through reverse mergers, in which Chinese private companies merged with United States-listed public shell companies, as well as through initial public offerings. The SEC sought access to work papers from the audit firms to understand the financials of the investigated Chinese companies and to assess and identify potential fraud. The SEC’s administrative actions against the Chinese units of the national accounting firms, as well as Judge Elliot’s decision, demonstrate that the SEC will not excuse an audit firm’s non-response to requests or non-production of work papers based on the firm’s desire to avoid violations of Chinese law. Nor will the SEC accept the argument that it should obtain those work papers only through the CSRC or other Chinese regulators. These actions also indicate that the SEC may be willing to bring enforcement actions against other auditors of Chinese companies listed on U.S. exchanges that refuse to cooperate with similar SEC requests, whether or not it has first tried to obtain the work papers through the CSRC or other Chinese regulators.
While the ruling will not affect 2013 audits, and an appeal could delay the ruling’s effect on China-based U.S. issuers for several years, these Chinese companies will be required to find new auditors during the suspension period if the ruling is upheld. Other accounting firms seeking to audit Chinese companies doing business in the United States will face increased risks and challenges. The effect of the ruling on United States-based multinational corporations doing significant business in China—who may use Chinese units of the national accounting firms to review their operations in China—is unclear. An audit firm must be registered with the PCAOB if it plays “a substantial role” in preparing or furnishing an audit report with respect to any U.S. issuer. Under PCAOB Rule 1001(p)(i), an auditor plays a “substantial role” if the auditor performs the majority of audit procedures on a subsidiary of an issuer whose assets or revenues constitute more than 20 percent of the assets or revenues of the issuer. Thus, the suspension may prohibit the Big Four’s Chinese units from performing work on the Chinese operations of United States-based businesses if their Chinese operations constitute a significant portion of those businesses’ revenues.
The appeals process will take time, and the final effects of the ruling remain to be seen. The ruling, if eventually upheld, will at the least have a significant future impact on the ability of Chinese companies doing business in the United States to obtain audited financials. The ruling also demonstrates that tensions between U.S. regulators’ desire for access to the financial information of Chinese companies doing business in the United States and Chinese regulators’ concerns about secrecy laws have not been resolved by the MOUEC, but may continue to affect the work of companies, regulators, and auditors in both countries.
Keywords: professional liability litigation, Sarbanes-Oxley, China, subpoenas, SEC, auditor
Sarah Scott Peters is an associate at Sutherland Asbill & Brennan LLP, in Atlanta, Georgia.
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